On October 2nd, the Supreme Court of the United States put to bed CHIP v HSTPA by denying hearing a challenge to the rent laws of 2019. Since SCOTUS historically takes two percent of the cases that come to their desk this wasn’t a big surprise but more like a batted down Hail Mary pass. For the most part, the market has already priced in a SCOTUS denial because rent stabilized buildings have been selling for the past four years mostly based on interest rates, location, and property condition – upside be damned. The laws today are no different than they were in September, therefore pricing shouldn’t be impacted on regulated buildings. But the immediate reaction from the market will likely be a slight reduction in prices because of the door being shut on landlords’ ability to raise the rent. The question we are all asking ourselves is what happens next?
Buildings that sold for 15x the rent are now worth 7x the rent and if you’re lucky NOI is flat. Sub 4% debt is more often than not expiring in the next three years. The 10 year treasury recently reached highs not seen since 2007. Current yields are north of 4.5% translating into almost 7% debt for borrowers. The rent stabilized portion of the Signature Bank loan portfolio (which is one of three catalytic events to bring inventory to market) is only going to sell with a massive FDIC government subsidy.
The increase in supply will drive pricing down as rates continue to climb or at best hold steady and bleed investors dry. Borrowers who have known all along their deals are dead likely see relief or answers from stubborn lenders who will now be forced to the table. Behind the scenes all the bankers knew they were eventually going to take a small haircut. Well, it’s their turn in line at the barbershop and despite asking for just a trim, their barber is going to take out the straight edge razor.
The banks are going to dictate what happens to most of the prewar housing stock in New York City. The problem they will face is operators who don’t want to continue to own the assets any longer. They have three options:
They can renegotiate their existing loans at below market rates and convert to interest only loans for the next couple of years until rates come down. This is known as extend and pretend.
They can sell the notes at significant discounts, likely at 50-80 cents on the dollar. This sizeable spread exists because unless the note owner makes a side deal with the borrower, they don’t know what they are buying; three years in bankruptcy court, or an amicable lunch date to hand over the keys on Monday in exchange for a small fee to avoid litigation. Mostly, they haven’t done diligence on the building’s paperwork to know the legality of the billable rents but a fee to the owner can solve this easily.
The bank and borrower can agree to hire a broker to market the property through a transparent process and each walk away with more money than they would have by taking the first two options.
No matter how the real estate gets transferred a few things will remain unchanged. First and foremost, the longer a sale gets delayed the worse this is for the tenants. Buildings fall into disrepair when a receiver is put in place because they have no skin in the game and can’t get money for basic repairs. Their incentive is often misaligned with a positive outcome. The receiver or administrator is paid to hang around and delay any outcome. Show me the incentive, I’ll show you the result. Second, the buyers of recycled real estate will be the same people who are also losing their comparable assets across the street.
Think of the distress like this: Rather than risk closing with a new buyer off the street with no credibility, sellers will be more likely to transact with experienced operators, convincing their board members they caught a bad break just like everyone else. The operators will lose one building but gain another and make a fee from a different set of investors who think they are presented with a great new opportunity. Round and around we go – the cycle resets itself right after everyone gets a little piece of the fee pie.
The biggest losers are the LPs: they get absolutely crushed. These are complete equity wipeouts and friendship destroyers. The LPs are the ones that have sunk the most money into the assets and the better the intentions the more you’ve lost. The good owners who spent money on renovations, capital improvements, lead remediation, energy compliance and security upgrades are the ones who will lose the most. The buildings with owners who didn’t substantially reinvest in their properties will be the first ones to fall into massive noticeable disrepair. Buildings with average rents below $1,400/month lose money even without mortgages. I’ve underwritten a lot of those buildings and it’s getting harder to figure out how cheap is cheap enough. These buildings are at least 80 years old, and they require just as much medical attention as any octogenarian. If you’re concerned about Medicare going bankrupt you should also be concerned about every rent stabilized building suffering the equivalent fate.
We’ve already started to see the capitulation. Older owners, estate sales and general exhaustion have resulted in long term owners throwing in the towel and selling. This will continue into 2024 because life is too short to waste on compliance and political grievances. The last decade was tolerable because people were making money. But now that cash flow is squeezed, compliance is increasing, and alternative investments are now attainable and attractive, you will see people who thought they would never sell…sell.